Economics Of Nobel Laureates by Tirupati Naidu Vangapandu - HTML preview

Chapter - 10

THEORY OF MARKETS

(Stigler, Simon, Oliver Williamson and Elinor Ostrom, Jean Tirol)

In the 1930’s, the dominant Perfect Competition market structure did not fit the fact of reality. Joan Robinson and Chamberline have developed a new theory of market structure. Joan Robinson explained her theory in The Economics of imperfect Competition and Chamberline discussed his views in Monopolistic Competition. While Joan Robinson discusses the imperfection in the market structure, Chamberline tries to blend both Monopoly and Competition and develop a theory of Monopolistic Competition. According to Chamberline Firms do not start in most cases with Monopoly but they strive to create monopoly by differentiating their products.

Let us give a brief account of the main features of each type of Market structure and explain how prices are determined under each category. In a Monopoly, there is only one seller and the product is unique and he has a large degree of control in setting either the price or quantity sold. The Duopolist refers to two sellers and Oligopoly refers to more than two but few sellers, whose products are either differentiated or homogeneous. Monopolistic Competition is a market where there are many sellers (both large Groups and Small Groups) whose products are differentiated but only slightly and who have some degree of control over price or quantity sold. The conventional model of Perfect Competition refers to a large number of sellers selling identical products and no single seller has any control over price and his Demand Curve is horizontal.

Under Perfect competition there is a free entry and e Hixit of Firms and there is no scope for excess profits by any single Firm in the long run. Since P is given, it’s P = M.R and it maximizes profit where P = M.R. =L.M.C =A.R=L.A.C.  At the given price, the firm’s M.R = A.R. is horizontal. The A.R. curve is tangent to long-run A.C. curve from belo!? Mi mi what up at the minimal point of A.C and M.C. curve cuts the A.C. curve from below at the minimal point of A.C. As there is free entry and exit of Firms, long-run equilibrium of the Firm under Perfect Competition is at point of minimum average cost. In the long-run, the equilibrium of the firm is given by P=M.R.=L.M.C.=L.A.C.  There are no excess profits

A monopolist is a single seller and he is the Industry. The demand curve for  his product is downward sloping and as such M.R is also downward sloping. The MC slopes upwards. The point of intersection of the downward sloping MR and upward sloping MC determines the equilibrium output. The demand determines his price. As compared to perfect competition, a Monopolist output is less and price is more. Under Monopolistic, competition, the demand curve for the product of a firm may be expected to have a negative slope, for customers will have different degrees of loyalty to the firms whose products are differentiated. In the short run, firms may earn excess profits. But in the long run Firms will enter and compete away the profits. Firms earn only normal profits.

Cournot model of Duopoly

Duopoly refers to a situation where there are only two sellers and oligopoly to more than two sellers (but few).  Augustine Cournot, in his book titled Mathematical Principles of the Theory of Wealth., proposed a Duopoly model, which is named after him. The model assumes: Two produces A and B produce identical products and have identical costs. For simplicity, Cost of Production is assumed to be zero and the total demand in the market they share is linear. Both Firms know exactly what the total demand is. Further both  accept the market price and neither sets it and each Duopolist, in making his own plan of output assumes that his rival’s reaction will be to maintain the same level of his output and each attempt to maximize profit the Duopolists act independently and do not collude.

We shall follow the explanation given by Stigler in discussing Cournot’s model.

Suppose two Firms each own a mineral spring whose water is much valued by customers. There are no costs of Production. Cournot proceeds to analyse the problem, subject to the assumptions mentioned above. Let the demand curve be P=I00-Q, and retain the condition of no Cost. In the case of Monopoly he maximises the total revenue, PQ (cost are zero)

TR = PQ = I00.Q – Q2

MR = I00 - 2Q (derivative of TR, wrt to Q)

Setting MR = MC, I00 - 2Q = O (MC = O),

2Q = I00, Q = 50 and P = I00 – 50 = 50

If there is only one producer, a Monopolist, his profit maximizing output is 50 and price is 50.

Using the same example, let us consider the case of Duopoly. I

Op loop hi guy op on I min

P=I00 - (QA+QB)

Step I. Let A set any output say, 40 which fetches a price of 60 (P = 100 – Q)

2). Then B will take A’s output as given, and seek the output that maximizes his (B’s) profits. The market for B will be the remaining part of the demand curve. In the case of a linear demand curve, the MR curve bisects the horizontal line drawn from the Price axis to the demand curve. Suppose a total demand curve (of both duopolists) is drawn and mark the A’s out put on the X axis and draw a vertical line to cut the demand curve.  From that point of intersection, if we draw, MR curve (of B) it will cut the remaining part of the horizontal axis in to half.  As Mc = 0, it is equal to horizontal axis.  The profit maximizing output for B will be exactly half of the Competitive output. Hence the output of B will be ½ (100 - 40) = 30. The price in the Market is

100-(40 + 30) = 30

3). Then A sets his output to maximize his profits, on the assumption that B’s output will be 30. Then A will produce ½ (100-30)=35

4). It is now B’s turn. It will produce ½ (100-35)=32.5

5). Then A will produce 33.75; then B will produce 33.125 and so on

This is an infinite series. The final solution will be for each Duopolist to produce is 331/3 units, with a market price of 33 1/3. Output supplied by the two Duopolists is 2/3 of the total of I00.

The Kinked Oligopoly Demand Curve

Paul  Sweezy developed the Kinked demand curve model to explain the price rigidity under Oligopoly.  The market situation contemplated by Sweezy is one in which rivals will quickly match Prices reductions, but only hesitantly and incompletely if at all follow price increases. This pattern of expected behavior produces a ‘kink’ at the existing Price.

There is no incentive for the Firm under Oligopoly to either raise the prevailing Price or decrease it. That is why Prices under Oligopoly remain stable.  If the marginal Cost curve passes over the range of discontinuity of the marginal revenue curve. Output and Prices remain unchanged at the existing levels.

Stigler:

After a thorough analysis of empirical evidence, Stigler concludes that “evidence reveals neither Price experiences nor the pattern of changes of Price quotations that the theory leads us to expect”.

Other Models:

There are other models Duopoly & Oligopoly.  In the Collusion model the two duopolists act in concert to maximize their joint profits.  In this model maximization proceeds in the same manner as in multi-plant monopolists.  A German Economist Stackel Berg developed a leadership-followership model of duopoly named after him.  According to the Stackelberg model, a firm which is a follower behaves exactly as the Cournot firm.  A leader takes advantage of the assumptions that the other firm is behaving as a follower.  The Market shares model of duopoly assumes that one firm always wishes to maintain a fixed share of the market and the other firm is willing to let it so.  In the Dominant firm model of Oligopoly the dominant firm sets the price for the product and other small firms who cannot have any influence on price will take the price set by the dominant firm as given and act as perfect competitors in determining their outputs.

In a real world situations, we come across other complex situations and pricing practices.  There are multiple products, and Joint products.  There are peak-load pricing of products, Full cost pricing and pricing of bundled goods. There is price discrimination for differentiated products under imperfect markets and there are different degrees of price discrimination.

Managerial Theories of Firm

So far, we have analyzed optimal pricing and output decisions of Firms under different markets structures, using the assumption of profit maximization as the objective of a firm.  As an alternative to profit maximization, Baumol suggests that Firms maximize sales revenue, subject to the constraint of earning satisfactory level of profits.  O. Williamson in his book, Economics of Discretionary Behaviour develops a manager’s discretionary behaviour model.  He argues that a manager of a large company, has vast control over the management of the company vis-à-vis the share holders (owners) of the company, who have little control over management of the company.  Williamson suggests that managers attempt to maximize managers’ utility.  Managerial utility primarily depends on 1) the salaries and other monetary benefits received by the manager, 2) the perquisites enjoyed by the manager, 3) the staff under the control of the manager, and 4) the extent to which the manager can direct the investment of Firm’s resourses.

Herbert Simon

Herbert Simon, who did his Doctorate in Political Science, has won the Nobel Economics Prize for his pioneering research into decision-making process within economic organizations and for his significant contributions to Organizations theory. While analyzing the Firm’s goal, Simon offered an alternative hypothesis to that of the Classical assumption of maximization of profits. Firms, while choosing a particular course of action among several courses available are satisfied with a limited objective of ‘satisfice’ than maximize profits.  It is a decision making strategy that aims at adequate rather than an optimal one.  The practice of a fixed mark-up over costs in determining market price gives one example of such behaviour.  Following the lead of Simon, others like Cyert and March have  attempted to develop  a Behavioral theory of Firm.

Transaction Cost Economics and Transfer Pricing

Though many have contributed to the discussion on transaction cost economics, Williamson’s contributions to the subject have been many and important.  His book ‘The Economic Institutions of Capitalism’ (Free press New York) provides a unified treatment of the subject of transaction costs.

Every transaction is placed within the context of a Firm.  When undertaking a transaction, parties to the transaction incur several costs like negotiating the contract and drafting the contract before entering into the contract.  Ex-post costs are incurred in consummating and safeguarding the deal that was originally struck. 

Transaction costs depend on two types of factors:  those pertaining to individuals who undertake the transaction and factors specific to the particular transaction.  Williamson assumes that human beings are boundedly rational and opportunistic.  The level of transaction costs depend on asset specificity, frequency and extent of uncertainty.

Firms in order to minimize transaction cost, choose to integrate vertically.  As a result, we find firms producing intermediate products required in making of the final product.  Suppose a car manufacturer enters into a contract with a producer of rear-view mirrors who makes them to the specifications of the car manufacturer.  The car company might prefer to produce its rear-view mirror in house, for example by buying the mirror company.  This would reduce time and resources spent over haggling over profits between parties to the transaction because decision would simply be taken by fiat.

Williamson’s theory can be tested against decision by companies to integrate parts of their supply chain.  Several studies have shown, for instance, that if an electricity generator producer buys its coal from a nearby coal mine, who is the only supplier, then the electricity generator company tends to own the coal mine.  Pricing of intra-firm transfer products between a parent company and its subsidiary or between divisions of a large company is termed transfer price.

A Firm corresponds to unified governance.  It is a legal entity in whose name various transactions are consummated with other firms and with individuals.  Firm’s governance structure needs to match to the characteristics of the transaction.

Transfer Pricing

A transfer price is the price one sub-unit (segment, department, division and so on) charges for a product or service supplied to another sub-unit of the same organization.  The transfer price creates revenue for the selling sub-unit and purchase costs for the buying sub-unit, effecting each sub-units income.  The product transferred between sub-units of an organization is called intermediate product.  Transfer pricing methods are widely and ably discussed in Managerial Economics Text books and Cost Accounting Books for Managers.

Williamson discussed above, won the 2009 Nobel Economics prize jointly with Elinor Ostrom.  Williamson borrows insights from Organizational Theory and Behavioural Economics and uses them in his theories of Firms and Organizations.  Elinor Ostrom, a political scientist devoted her whole life for researches in Economic governance, especially relating to common property resources.  Standard economic models predict that in the absence of clearly defined property rights, common property resources such as pastures and fisheries will be over exp0loited.  Over grazing and over fishing will result.  In her book on Governing Commons (1990) Ostrom argues that people using these common resources formulate rules and regulations of governance which work much better than Government regulations.   Ostrom concludes that there are ways of solving collective action problems within the public sector as well as in the private sector. She suggests that we should learn from highly successful policies the best policies to follow as guidelines. Her researches on policy analysis in the future of good societies titled MUSE can be downloaded through the internet (http://muse/hvoedu/gso/summary/ostrom.html)

Williamson and Ostrom have focused attention on transactions within firms, households and agencies.  They have used economic analysis to explain these institutional arrangements and their governance.

Jean Tirol, a French Economist wins the Nobel Prize in 2014.  While awarding the Noble Economist Prize to Tirol the award committee mentions is research on Market Power and regulation which helped Governments understand and regulate industries dominated by a small number of dominant firms are a single Monopoly.  Left un-regulated, such markets often produced socially un-desirable results – prices higher than casts, or unproductive firms that survive by blocking entry of new and non productive funds.  Tirol analyzed such market failures.  His work has a strong bearing on how Governments should deal with mergers or Casters and how they should regulate monopolies.

In his books Dynamic Models of Oligopoly, The Theory of Industrial Organization, The Theory of Incentives and Regulation and Procurement and in a series of articles Tirol has presented a general framework for regulatory policies for application to number of Industries ranging from Tele Communications and Banking.